Why has the billion dollar valuation become trivialized in startup investing?

What started Facebook down a path where it would it reach a $150 billion valuation on secondary markets before going public at a $100 billion valuation, and then sinking to a $50 billion valuation within months?

We were talking about these questions with the CEO of a startup that has itself raised more than $100 million in this environment.

This CEO believes the answer to these questions are in the chart below, which shows how the yield on corporate debt has declined for the past 22 years:

After targeting these startups, these VCs approach them about investing. But the VCs don't want normal "common stock;" they want stock with special rights. These "preferred shares" guarantee their owner that, in the event of any sale, the owner will, at the very least, get the price paid for the stock back. If the VC invested $10 million in Startup X at a $100 million or $200 million valuation, that VC will get at least $10 million back, even if Startup X only sells for $10 million.

To convince the startups to sell them this preferred stock, the VCs agree to pay more for it. The way they pay "more" is not by investing more, but by acquiring a smaller percentage of the startup with the same amount of money – by giving the startups much higher valuations.

These higher valuations mean that VCs have lower potential reward. But the special rights also make VC a less risky investment.

Combined with a decline in yield for corporate debt, that makes venture capita a more attractive sector for large pension funds and other institutional investors to put their money.

So the money has come flooding into VC.

This, in turn, makes the competition for the few high-profile, hyped startups that much more frothy. In competition with each other, VCs become more willing to "pay more" for their preferred shares, and startup valuations get higher and higher.

In 2007, Microsoft bought $250 million worth of preferred Facebook stock at a $15 billion valuation.

Recommended For You

The Board Room

Editors' Picks

More amazing, considering the zero risk you've pointed out that such investors actually incur, is that they get preferential tax treatment (15% vs ordinary income tax) on any additional income from these investments, on top of their already substantial and guaranteed salaries.